In the world of oil and gas, we know that production cash receipts and income tend to lag a month or two (or sometimes three) behind when the volumes are produced. This is due to a variety of factors, including the time required to read meter charts, shipping to the marketer, and processing of the payments.
Generally Accepted Accounting Principles (GAAP) require that income be recognized when it is earned, not necessarily when it is paid, and also that related expenses need to be recognized when incurred, not when you actually write the check to pay for those expenses. If your company’s goal is to produce GAAP-compliant financial statements, it’s imperative that you have a good estimate of oil and gas produced but not yet paid at the end of the month/quarter/year.
There are several ways to estimate accrued revenue and related expenses. Some are very high-level; for example, you might take volumes produced in November and December of last year and apply current prices to those amounts to estimate this year’s revenue. For the related expenses, if those are consistent and there were no major changes, you could use amounts paid out by your company last year in January and February to represent November and December expenses of that prior year. Another quick method would be to use an average of the oil and gas revenue and related costs in the first 10 months of the year (or nine or 11, depending on your accrual period), and then multiply that amount times the months in your accrual period. These methods generally work best if your production is consistent year over year and throughout the year, but any large price swings must be taken into account at the end of the year.
Some companies prefer to use a more precise method. They might use detailed production reports to get a better estimate of what they will be paid on. They might factor various basis differences into the equation, or possibly an average of indexes (Dominion, TCO, NYMEX, etc.). Much of this will depend on the company’s ability to gather data and whether it is indeed paid on different indexes or has basis adjustments (Dominion vs. NYMEX price, for example). Other reasons to use a more precise method include when a company grows substantially during the year, making last year’s amounts outdated, or if there is a significant change in commodity prices toward the end of the year that may skew any averages used.
Another option, which depends on how quickly financial statements need to be produced for a bank or for shareholders, is to simply wait until actual cash is received for amounts produced at year-end but not paid. For example, if a company historically receives cash for November and December production by February 15, of the next year, it might be more practical to just wait until that point to record a final accrual adjustment.
As with other accounting estimates, it’s important to remember that this is just an estimate. Your calculation of accrued revenue and expenses is never going to be exact to the penny. However, it’s important to have a reasonable basis for any estimates made, one that can be supported by data and historical financial information. Critical thought and sound judgment are required for this essential part of GAAP-compliant oil and gas financial statements.
In our next blog post, we will discuss the importance of getting an official reserve report, specifically for calculating plugging costs on your financial statements.
Hall, Kistler & Company has been helping producers in the oil and gas industry since we opened our doors in 1941. We know what it takes to produce proper GAAP financial statements for oil and gas companies and can provide guidance along the way. Let us help when you are coming off of the sidelines and BACK INTO THE GAME.